The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Tuesday, November 13, 2012

Ring-fence versus transparency: gamble versus sure thing

The more the UK financial regulators tell Parliament about their proposal to ring-fence the banks, the clearer it becomes that they are uncertain if it will work as intended.

Why would anyone adopt reform with an uncertain outcome when they could adopt reform with a known outcome?

With ring-fencing, the UK financial regulators are asking Parliament to gamble in the hopes that it will work.

In a Guardian article, John Vickers, the man behind the ring-fence idea, expresses his hope that it will work and that when combined with higher capital requirements it will get taxpayers 80% of the way to not having to bailout the banks again.

With ultra transparency where the banks are required to disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, Parliament could adopt reform that is a sure thing.

With ultra transparency, taxpayers get 100% of the way to not having to bailout the banks again as the era of bailing out the banks for fear of financial contagion is ended.

Using this information, market participants can independently assess the banks and adjust their exposure to each bank based on both the bank's risk and the participant's capacity to absorb financial losses given this risk. Since each participant can afford to absorb the loss on their exposure, there is no reason for the taxpayer to step in.

Ultra transparency also ends bailouts that result from the moral hazard that arises from financial regulators possessing an information monopoly, running stress tests and pronouncing the banks solvent. When market participants have the same information as the financial regulators, they can run their own stress tests and therefore have no need to be bailed out after relying on what the financial regulators say.

It is very well known, including among financial regulators and academics, that sunlight is the best disinfectant.

Not only will ultra transparency bring an end to an era of bad behavior by bankers, but it will subject the banks to market discipline for the first time in at least three decades.

Market discipline that will restrain risk taking.

For example, it will virtually eliminate proprietary trading when combined with a Volcker Rule prohibition as market participants will enforce compliance.

It is also very well known that ultra transparency has other benefits.

It restarts the interbank lending market as banks with deposits to lend would have access to the information they need to independently assess the risk of the banks looking to borrow. With the interbank lending market restarted an transparency into every trade, Libor can be based on actual trades and no longer be subject to manipulation by the bankers.

The UK Parliament faces a choice: gamble with ring-fencing and hope this changes the culture and reduces the risks taken by the banks or adopt a sure thing with ultra transparency and know they have changed the culture and reduced the risk taken by the banks.

The architect of proposals to ringfence retail banking conceded on Monday that the government should retain the power to break up banks completely.

But Sir John Vickers, who chaired the Independent Commission on Banking (ICB) which recommended ringfencing, also told MPs and peers that he believed ringfencing – and not total separation – would be effective.

"I believe the ringfence will work. With the legal and other safeguards it will work, including on the cultural aspect," Vickers said to the parliamentary commission on banking standards.

It is unacceptable after the global financial crisis to adopt reform based on the "belief" it will work when there are proven alternatives.

He admitted that fear of an enforced breakup could be used to put pressure on banks that were trying to avoid the rules.

The government is giving the banks until 2019 to put up a ringfence between their high street and investment banking arms....

Asked by Tyrie whether a full break up should be included in the legislation in the event banks fail to install the ringfence, Vickers said he could not "resist" the idea even though he believed the threat would not be needed.

Vickers said: "If the industry turned out to be unreformable, and I'm not so pessimistic as to think that, then it's possible that total separation would turn out, in due course, to be the better step to take." But he stressed he did not see ringfencing as a path towards full separation....

We already know that the industry is reformable if it is subjected to transparency.

This solution was implemented following the Great Depression and lasted for 7+ decades.

This solution would have prevented our current financial crisis if the financial regulators had kept opacity out of the financial system.

Vickers, regarded as a candidate to become the next governor of the Bank of England, made clear the he felt the ringfence went far enough to "improve banking stability and competition".

"I am firmly with the recommendation we made. I believe that full separation would have had higher costs and for a gain that might not even be positive," Vickers said. He is concerned about the risk of having banks that solely focus on the retail sector.

The beauty of ultra transparency is that it does not require the banks to become solely focused on either the retail sector or investment banking. They can do one or both.

What ultra transparency does do is restrain risk taking regardless of which sector banks chose to operate in by instilling market discipline.

The ringfencing proposals, along with demands by international regulators in Basel, Switzerland, for banks to hold more capital, were a "decent start" to stop another taxpayer bailout.

Implemented altogether, Vickers said that "we are on a path … that would take us most of the way" – three quarters to 80% – to avoid a guarantee for the sector from the taxpayer".

Speaking for the global taxpayers, we are not interested in a "decent start" or even a start that gets us 80% of the way to avoiding another taxpayer bailout.

Based on recent past experience, we know banks will continue to gamble and we will be called on under the 20% that remains.

The only known, proven solution that gets 100% of the way to avoiding another taxpayer bailout is requiring the banks to provide ultra transparency.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.